If you can be convinced to set up a self-managed super fund, the fees go to the advisor. If you stay in externally managed super, the fund manager wins.

Of late, advisors have outflanked their opponents and the benefits of an SMSF have been flying like a hail of arrows, piercing the arguments of fund managers desperately trying to defend themselves and their lucrative fee entitlements.

But do the arrows hit the mark? Is an SMSF really worth the effort?

The Pitch

The following extract from the website of Dixon Advisory is pretty typical of the arguments presented in favour of establishing an SMSF.

This is not to single out Dixon Advisory, but merely to show how SMSFs are presented. And why not? If all these benefits are true, it certainly looks attractive.

The Reality

Let’s step back from ‘SMSF wonderland’ for a moment and look at the trade-offs.

Externally managed super has one major benefit—tax. Everything else, including lack of investment choice and fees, is a trade-off to get the concessional (deductible) contributions and the 15% (or 0%) tax rate. SMSFs have an extra set of trade-offs. The trick is to weigh them up so you can make a decision that’s in your own best interests.

Here’s when you should consider setting up a SMSF:

You have a large portfolio and the fixed costs of running (and investing) an SMSF are likely to be less than the percentage costs paid to an external manager;

You are a skilful investor and believe you can significantly outperform an external manager;

You wish to invest a significant portion of your super into investments or otherwise take advantage of opportunities not available (or more expensive) on an externally managed platform;

You want to hold a significant amount of cash (SMSFs are often able to access term deposit rates higher than the cash options in an externally managed fund);

You want to actively manage the tax affairs of a SMSF to suit your personal circumstances. (Note that product peddlers often highlight a SMSFs 15% and 0% tax rates as benefits. These benefits aren’t exclusive to SMSFs. External super gets the same treatment.)

You’ll notice one heavily marketed feature not on the list: the ability to borrow (on a limited recourse basis). Let’s explain why.

The above five criteria typically won’t all be positives. You may, for example, have a large portfolio and be attracted to the cost savings. But a lack of time, focus or skill as an investor may cost you more in lost earnings than the amount you are saving in costs. So you win with one hand and lose more with the other.

If you are a highly skilled investor with time on your hands, a large super balance, a desire to hold unusual investments or large amounts of cash and have a working knowledge of the tax system, a SMSF makes perfect sense.

But most people don’t fit this mould entirely; certainly not enough to explain the $390.8bn of assets in self managed super funds. So how do you decide? Let’s consider some key topics:

1. The minimum required balance to make an SMSF cost-effective

The figures typically quoted are anything from $50,000 to $500,000, with $200,000 being something of a consensus.

But it depends on where you stand on other factors. If you have the time and inclination to dedicate yourself to investing and administration—and the necessary skills—then you might be able to get away with a balance at the low end of this range. If you plan to make significant contributions in coming years, even better—your balance will be growing rapidly.

Remember that you are setting up a SMSF for the long haul. It is not so much your current super balance that should determine your answer to this question but your future expectations of it.

On the other hand, you might be a time-poor person with a $500,000 super balance but with little interest in investing or managing your tax affairs. Despite the large balance, if the money is just going to end up back in managed funds then it might not make much sense to add another layer of fees by setting up an SMSF.

Cost (discussed below) is a critical factor in the minimum balance question. The higher the costs and the more help you need, the greater your SMSF balance needs to be.

2. The nature of your investments in an SMSF

SMSFs make sense for those with an active interest in managing their own investments. They’re also attractive for those wanting to buy unlisted or physical assets such as private equity funds, venture capital, art or direct property—options typically not available with external super.

There is one important point to keep in mind. As discussed in our Telstra article, the tax rate ‘discount’ for SMSFs is greater on income (interest, rent, dividends) than it is on capital gains. Because of this, if your overall portfolio is greater than your super balance, you will be better off in most cases putting income generating assets in your SMSF first.

If you are a passive investor in the share market but an active investor in venture capital (which is more likely to generate capital gains than income), you may not be achieving much by setting up a SMSF. In this case you might be better sticking with an externally managed share fund and holding the venture capital investments in your own name, a private company or a family trust.

Ultimately, it comes down to what your overall portfolio (both super and non-super combined) looks like. If you have $200,000 in super and $250,000 overall in managed funds, you may find you can replicate your managed fund investment through external super and save yourself the hassle and cost of a SMSF.

If the managed funds generate similar income to your other investments—and are about as likely to generate gains—from this perspective at least, an SMSF isn’t achieving much. And there’s always the option of setting up an SMSF down the track if your circumstances change.

One final point: SMSFs are quite good for holding cash, term deposits and bonds. Cash only returns you income (in the form of interest) so you are getting the maximum SMSF tax ‘discount’. And SMSFs can often access better cash and term deposit rates than are available through external super platforms. Many institutions lump SMSFs in the same basket as retail customers when offering ‘special rates’.

Finally, and barring a collapse of the Australian banking system, cash doesn’t carry the risk of loss. So you aren’t going to end up filling up your SMSF with losses, which make the low tax rate a penalty rather than a benefit.

Of course, if you are going to set up an SMSF and fill it with cash you need to make sure you have a well-stuffed stocking. An additional 1% in interest on a $100,000 balance will be quickly consumed by additional costs.

3. Establishment and ongoing costs

This is highly dependent on your situation. What follows is therefore only a rough guide.

Set-up costs: About $1,500 for trust and corporate trustee and $5,000 including advice;

Off-the-shelf SMSF through an online service - $1,000-$2,000 a year;

Tailored fund without financial advice: $3,000-$4,000;

Full service, including administration, accounting and advice: $5,000-$10,000.

You will need to get quotes before you make a final decision. Remember there will be ‘one-off’ costs from time to time—your trust deed might need updating for instance—so any quote should be regarded as the bare minimum. And don’t forget that you are likely to need help if you have a tax audit or when you’re moving into ‘pension mode’.

Finally, the reason off-the-shelf SMSFs are cheaper is because they’re ‘one size fits all’; flexibility is limited. That’s not necessarily a bad thing and may not impact you at all but it is another trade-off to consider.

4. Your investing skills and portfolio size (1)

Many people interested in setting up SMSFs do so because they want to invest directly in shares rather than pay an external fund manager to do it for them.

If you have a large enough portfolio—and your performance won’t suffer with you managing it—an SMSF makes sense. With $1m to invest, it’s better to pay $3,000 a year in costs than 1% in management fees. But if you have only $100,000 in super, then you really do have a trade-off to consider.

First, be honest with yourself about your investing skill. If you end up with poor performance and then recruit an advisor to step in or park your super money in managed funds, it’s going to be an expensive exercise.

If you think you can do better than in a managed fund, weigh up the additional cost of your SMSF against your performance expectations. Using the cost numbers above you might be giving the fund manager a 2% head start. How confident are you that you can outperform by more than this amount?

We suspect many people have set up SMSFs as an emotional reaction to paying fees to poor-performing fund managers. But you don’t get better returns by paying fees to advisors and accountants instead. And it doesn’t make sense to suffer lower returns or admin headaches just so you can ‘take control’.

5. The power of competition

For those largely focussed on share investing there is another factor to consider: The move by external fund managers to offer ‘share trading’ within external super funds. They have fought back with arrows of their own.

Australian Super, for instance, offers a Members Direct option which allows members to buy and sell the top 300 shares listed on the ASX.

If you can live with a bit less flexibility then this may satisfy your needs without needing to make the SMSF jump. And, as the battle for the super dollar intensifies, the range of options—and the number of managers offering them—will be only likely to increase.

6. Alternative investment vehicles

The good old family trust or private company has been forgotten in the rush to SMSFs but they’re worth bearing in mind.

While not offering the same level of tax benefits as super, they can still save you tax. And they typically offer more flexibility, less administration headaches, lower costs and less regulatory risk than super.

The latter tends to be underestimated. If we were going to put a bet on changes over the next decade or so, it wouldn’t be lower tax rates, higher contributions caps and more flexibility. Super is a political issue and any major changes to it are likely to be to the detriment of super members. Trusts certainly have their own regulatory risks but they have been around for far longer and don’t have the same visibility. [We’ll examine the uses of trusts in future articles]

7. Doing it all yourself

Some brave souls don’t just manage their own investments, they administer their SMSFs too, keeping accounting and advisory costs to a minimum.

This is great for reducing ongoing costs but has one potentially major sting in the tail: the ‘stuff up’. SMSF management is an incredibly complex area with constantly changing rules. The consequences for getting it wrong can be incredibly expensive.

There are many stories of people who’ve made minor, unintentional breaches and ended up with a huge tax bill. This is a path only for the brave, experienced and committed.

For the right person an SMSF can be a vast improvement on externally managed super. But you do need a good understanding of what you are doing, or be willing to pay someone who does.

If you are time poor, have a lower balance, or don't need the full flexibility of an SMSF, then you need to think long and hard about whether it's the right option for you.

Myth busted?

To a degree, the advisors pitch is correct: SMSFs do offer greater control and flexibility. But, depending on your balance, skill and interest, they come pre-loaded with additional risk and cost. You need to assess how the pros and cons stack up for you.

A SMSF won’t give you a lower tax rate than external super but it will provide more tax ‘flexibility’, so long as you avail yourself of it. And it won’t give you ‘lower fees and better performance’. That depends on your super balance and how well either you or your adviser performs.

The widely-held belief that an SMSF is necessarily a good thing is not a total myth—they make good sense for some and no sense for others.

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Footnote (1):

The Commonwealth Government report, A Statistical Summary of Self Managed Super Funds, is often quoted in marketing material to support the case for SMSFs over external funds. This is despite the fact that the Report itself states quite clearly:

… “direct comparisons between SMSF and non-SMSF sectors need to be qualified due to differences in the way the data are collected by the ATO and APRA” …

All statistics quoted in support of a marketing pitch need to be taken with a grain of salt. But these statistics are specifically noted by the preparer of the report as not being an "apples vs apples" comparison.

In addition, given we are talking only about the period 2006-2008, there are any number of random factors that can impact the analysis. Remember this period includes both the greatest financial crisis the world has ever seen and the 'transitional period' where investors were able to contribute up to $1m to their SMSF. Investors who were slow to move shares into their SMSFs would have seen their SMSFs outperform the market significantly simply due to luck.

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